Distribution of control over capital

GROUP 9 : GROUP 9 The Distribution of Control Over Capital


Corporate Governance, Economic Entrenchment, and GrowthRANDALL MORCK, DANIEL WOLFENZON, and BERNARD YEUNG : Corporate Governance, Economic Entrenchment, and Growth RANDALL MORCK, DANIEL WOLFENZON, and BERNARD YEUNG


Points to Address… : Points to Address… Look at how investors are able to control vast amounts of capital they actually own How the concentration of capital affects property rights protection, the functioning of capital markets, and economic growth


Slide4 : James – Article Introduction & Preliminary Reading on Inherited Wealth & Growth Eimear – The Purpose of the Control Pyramid & Their Potential Benefits Grainne – Control Pyramids & the Separation of Ownership from Control Nick – The Implications of Control Pyramids Mark – Political Economy Considerations & Conclusion


Slide5 : ARTICLE INTRODUCTION Papers before have indicated that economics growth depends on the distribution of control over capital assets Aghion, Caroli and Garcia-Penalosa (1999) identify that perfect capital markets make wealth distribution irrelevant by allocating capital to each investment opportunity until its marginal return equals the market clearing equilibrium interest rate Wealth redistribution from rich to poor lessens borrowing in the economy, increasing overall production and reducing the cost of debt financing on the margin. The literature surveyed throughout the article suggests that the functional efficiency of capital markets depends on the distribution of corporate control in an economy


Slide6 : In particular, this literature views economic growth as critically dependent on institutions that restrain entrenched elites Rafael La Porta, Lopez-de-Silanes and Scheifer (1999) introduced us to control pyramids This concentrated control can lead to corporate governance concerns – a range of agency problems, bias capital allocation, harmed capital market development, obstruction to entry by outsider entrepreneurs and stifled growth in the economy These implications can be serious, and also known as ‘economic entrenchment’


Slide7 : INHERED WEALTH AND GROWTH They combine ‘Morck, Strangeland & Yeung’s paper and Forbes’ top 1000 wealthiest individuals in the world list, and distinguish 2 groups: - New money millionaires – made money themselves - Old money billionaires – inherited wealth After analysing, they find new money billionaire wealth to be associated with faster economic growth Also find that inequality involving new money wealth seems different from old money wealth. To explore this, we must examine how highly concentrated wealth can translate into even more highly concentrated corporate governance power…


CONTROL PYRAMIDS : CONTROL PYRAMIDS


Corporations have dominant owners : Corporations have dominant owners


La Porta, Lopez-de-Silanes and Shleifer(1999) : La Porta, Lopez-de-Silanes and Shleifer(1999)


STRUCTURE DIAGRAM : STRUCTURE DIAGRAM


EXAMPLE ON PAGE 663 : EXAMPLE ON PAGE 663


REAL WORLD : REAL WORLD


SUPER VOTING SHARES : SUPER VOTING SHARES


EXECUTIVE POSITIONS : EXECUTIVE POSITIONS


OTHER TYPES OF GROUP CONTROL : OTHER TYPES OF GROUP CONTROL


EXAMPLE : EXAMPLE


WEALTHY FAMILIES CONTROL ECONOMIES : WEALTHY FAMILIES CONTROL ECONOMIES


1) THE PERFORMANCE OF FREESTANDING FAMILY CONTROLLED FIRMS : 1) THE PERFORMANCE OF FREESTANDING FAMILY CONTROLLED FIRMS


1) CONTINUED : 1) CONTINUED


2) COULD CONTROL PYRAMIDS HAVE POSITIVE EFFECTS? : 2) COULD CONTROL PYRAMIDS HAVE POSITIVE EFFECTS?


2) CONTINUED : 2) CONTINUED


BUT,WHY PYRAMIDS? : BUT,WHY PYRAMIDS?


Slide25 : Control Pyramids and the Separation of Ownership from Control.


Slide26 : Reasons for skepticism: A pyramidal corporate ownership structure allows the controlling shareholder to secure control rights without commensurate cash flow rights- protecting the controlling owner from losing power- entrenchment Controlling shareholder’s low cash flow rights lead to agency problems In family- controlled pyramids, family members often retain top management positions often leading to negative effects as management positions do not always go to the most capable person. Almeida and Wolfenzon argue that efficient allocation of resources within a group (if efficiently allocated) can exacerbate the inefficient allocation of resources across groups Concentrated control by few families gives them market power leading to undesirable economic consequences


Divergence of Interests Agency Problems. : Divergence of Interests Agency Problems. Berle and Means (1932) describe pyramids as having problems like those of widely held firms. Jensen and Meckling (1976) argue that the managers of firms with dispersed shareholders have substantial discretion as to the actions they take because individual shareholders cannot coordinate to share monitoring and control costs. Managers then take actions with benefits not shared with shareholders known as Private benefits of control. These are: Indirect financial benefits Direct financial benefits Intangible benefits


Slide28 : Pyramids allow a family to retain control of many firms while holding only a small fraction of their cash flow rights. By allowing cash flow rights and voting rights to diverge, control pyramids permit the same divergence of interest problems as dispersed ownership, even though the firms in the pyramid are not widely held. This divergence of interest can lead to inefficient investment in firms in which a controlling owner has a small cash flow rights because they only earn a small part, corresponding to its small cash flow rights in such a firm, of any investment’s monetary payoff but can retain all of any private benefits the investment generates.


Slide29 : A related reason for inefficient investment arises from oppression of public shareholders by the controlling shareholder. This is where inefficient investment arises from the high cost of capital that this divergence of interest entails. This high cost stems form minority shareholders’ rational expectation that this divergence of interests distorts corporate decisions to benefit controlling shareholders.


Entrenchment Agency Problems : Entrenchment Agency Problems Jensen and Meckling (1976) argue that that insiders with larger stakes have less incentive to misallocate corporate resources, however Stulz (1988) argues that higher equity stakes also give insiders more freedom to misallocate resources. Entrenchment problems can take on a qualitatively distinct air as it can lock in control by honest but inept insiders as well as clever self- serving insiders.


Slide31 : Almazan and Suarez (2003) argue that a degree of entrenchment might be part of an optimal compensation contract for top managers. Aikawa emphasized a fundamental reason of control pyramids is precisely that they lock in control, that is, a pyramidal structure is itself a means to entrench the controlling shareholder without the cost of maintaining a large equity stake. Control pyramids per se are simple and highly effective anti-takeover devices.


Tunneling. : Tunneling. The act of transferring value from one pyramid firm to another is dubbed tunneling by Johnson, La Porta, Lopez-de-Silanes and Shleifer (2000). Value can be transferred between controlled firms via transfer pricing, the provision of capital at artifical prices; or via inflated payments for intangibles such as patents, brand names, and insurance. Tunneling does not require a control pyramid of firms, however, tunneling is plausibly a more everyday concern in economics dominated by control pyramids.


Slide33 : Tunneling exacerbates problems by allowing an entrenched controlling shareholder to appropriate corporate resources and to raise a corporate veil against outsider monitoring. Emperical Evidence: Firm- level studies of performance. Friedman, Johnson and Mitton (2003) present evidence consistent with transfers of wealth from controlling shareholders benefiting public shareholders in pyramids firms Jae- Seung Baek, Jun- koo Kang and Kyung Suh Park (2004) report that pyramid firms tightly controlled by wealthy Korean families exhibit worse stock market performance than independents. Graham (2003), Kang (2002) document the history of scandal, political rent- seeking and bailouts that characterizes Korean pyramidal groups.


Slide34 : The Empirical Importance of Entrenchment Problems. Entrenchment problems are clearly important in the US and are likely to be even more important in other countries First empirical evidence now recognised as indicative of managerial entrenchment is Johnson, Magee, Nagarajan and Newman (1985) who report that stock prices often rise significantly upon the announcement of CEO sudden deaths. A low sensitivity of top manager turnover to firm performance may also indicate entrenchment. Volpin (2002) shows that, when the controlling shareholder is also the CEO, CEO turnover is largely unrelated to firm performance. He finds that family members are replaced less often than professional managers and that their sensitivity of turnover to performance is significantly lower than that of nonfamily.


Slide35 : Valuing the Private Benefits of control. A way to measure corporate insiders’ private benefits from control is to estimate the value of market attaches to control rights. If this value is positive, market participants believe that the controlling party obtains benefits over and above those that are shared with public shareholders. This is evidence o entrenchment, without entrenchment, these benefits would be ephemeral for public shareholders would react by selling to a raider or supporting dissidentsat a shareholders’ meeting.


Slide36 : Two ways to measure value of control: To infer it from the block premium- the difference between the price per share paid in a block transaction and the market price after the transaction. Based on the difference between the market prices of different classes of stock. Work on how these measures vary over time in response to institutional changes, legal reforms, and the like would be of great value.


Slide37 : Entrenchment, Private Benefits of Control and Pyramids. Claessens, Djankov, Joseph Fan and Lang (2002) examine 1996 data on 1, 301 publicly traded corporations in eight East Asian economies. Their study shows that firm value , measured by market to book ratio rises with the cash- flow rights of the largest shareholder and falls as the control rights of the largest shareholder decline relative to their cash- flow rights. This result is consistent with controlling owners having less concern for maintaining the value of firms in their lower control pyramids.


Slide38 : Sung Wook Joh (2003) re-examined this using data form Korea, where the corporate sector is largely dominated by large family controlled pyramidal groups or Chaebol. He finds a higher excess of control rights over cash flow rights associated with lower profitability. Again this is consistent with controlling owners having less regard for the financial performance of firms lower in their pyramids. Lins (2003) uses 1995 data o 1,433 firms from 18 emerging markets to study large equity blockholders and reports that 2/3 of insider controlled firms belong to control pyramids and that insiders’ voting rights average 2.7 times their cash flow rights. This is consistent with more pronounced agency problems in firms in lower tiers of control pyramids.


Slide39 : Johnson, Boone, Breach, and Friedman (2002) point out that the controlling owners’ diversion of resources may depend on the anticipated future need for outside financing in each firm in a control pyramid or other group. Mitton (2002) compiles a sample of 398 firms in 5 East Asian countries and finds that firm performance during their financial crisis is only marginally affected by the divergence between cash flow and voting rights.


Slide40 : Tunneling The studies carried out that link the excess of a controlling owner’s control rights over his cash flow rights to depressed financial performance or firm value are consistent with either tunneling or a simple neglect of the interests of public shareholders in lower tier pyramid firms. Bertrand, Mehta, and Mullainatham (2002) (in a study conerning Indian family control pyramids)find that control pyramid are consistent with tunneling and are difficult to explain with any other hypothesis. However a few papers did not find evidence for tunneling in pyramids like Holmén, and Hogfeldt (2005).


Slide41 : In summary: Family control pyramids allow the simultaneous presence of divergence of interests agency problems and entrenchment agency problems meaning that family control pyramids are potentially subject to worse agency problems than freestanding firms The overall consequence is that these firms may under perform from an asset utilisation viewpoint and the lack of the effective external monitoring in pyramid firms whose governance is dominated by powerful families may deprive managers of effective investor feedback regarding invstment decisions.


Pyramids &Politics : Pyramids & Politics


Key Areas : Key Areas Political Economy Framework Political Influence Determinants of Economic Entrenchment Summary


Political Economy Framework : Political Economy Framework This framework applies to capitalist economies. Extent of concentration of corporate power can arrange capitalist economies along a metric with two endpoints of: Diffuse Capitalism Oligarchic Capitalism These two ends of the scale represent two different political economy outcomes and that institutional development is endogenous.


Structure of a political economy framework : Structure of a political economy framework Lopez-de-Silanes, Schleifer and Vishny (1998) argue that sound capital institutions and capital markets depend on an effective political framework and a range of customs, rules, laws and regulations. Legal Rights of public shareholders Sue directors, cumulative voting, call extraordinary shareholder meetings Enforcement of legislation The rights of shareholders are only meaningful in they are enforced by judiciary, police and regulators A general absence of corruption is needed for effectively functioning capital markets


Structure of a political economy framework : Structure of a political economy framework Accounting Transparent accounting and disclosure Accounting standards, auditing, penalties for not complying Entrepreneurs The rights of aspiring entrepreneurs have to be protected as well, as these people are an integral part of economic growth. Where government corruption is high, entrepreneurs general face great difficulties when trying to become a registered firm. These rights combined are commonly known as an investors private property rights. It has been proven that the level private property rights is directly correlated with capital market efficiency, so this effectively means that the government can determine capital market functionality.


Political Influence - Oligarchs : Political Influence - Oligarchs Oligarchs aim to have an influence politically in order to attain policies that preserve and expand their corporate governance power – This in turn preserves and expands their resources for further political lobbying. This is gained by political lobbying, the aim of which is to: Impede new market entrants Reduce public investors personal property rights Raise trade and capital barriers Implementation of any policy to their advantage The concurrence of oligarchic capitalism, weak institutions and slow growth in a stable but Pareto-inferior equilibrium is known as economic entrenchment.


Political Influence - Oligarchs : Political Influence - Oligarchs There are several reasons for believing that oligarchic families and groups are effective lobbyers, specifically they are thought to have particularly low lobbying costs: 1) - Controlling owners of great control pyramids have vast amounts of resources at their disposal to make side-payments to officials. New entrants are usually short of capital so can’t afford this and have to promise future payments, this is perceived as a risky investment for officials as many new ventures fail.


Political Influence - Oligarchs : Political Influence - Oligarchs 2) - Lower transactions costs A control pyramid can pool resources quickly and easily to make side-payments to politicians. In contrast, a group of individual investors or firms will incur high coordination costs to gather a similar payment. 3) - Favour trading, this is between corporate and political insiders trading favours now for future reactions. A CEO of a widely held firm may feel little obligation to uphold promises of a predecessor, oligarchic families can keep better faith over time.


Political Influence - Oligarchs : Political Influence - Oligarchs 4) - Tunnelling of resources between firms Controlling owner can pay politicians from lower tier firms for favours that benefit higher tier companies, so public shareholders pay for lobbying benefits of the group. Payments can be made as discretely as possible to officials e.g. to private firm with little governmental business. 5) - Connections between friends and families Corporate and political insiders may be the same people or at least in the same family.


Political Influence - Oligarchs : Political Influence - Oligarchs Gazprom & Viktor Chernomyrdin: Chernomyrdin was a director in Gazprom before becoming Prime Minister, after his entry into government it was widely reported he continued links to Gazprom. Embassy sources reported that Chernomyrdin spends a significant amount of his time on 'Gazprom' business. An aide to current 'Gazprom' director Rem Vyakhirev said recently that, when there are problems in his sector, 'they (the federal government) do not tell us what to do, we tell them what needs to be done.


Political Influence - Oligarchs : Political Influence - Oligarchs Also it was ensured that they paid minimal taxes. One expert estimated that Gazprom's tax breaks cost the Russian budget up to $30 billion. Gazprom had provided funds for Chernomyrdin's parliamentary campaign in December 1995. During the firm's privatization Viktor Chernomyrdin illicitly obtained significant holdings of stock in Gazprom, and was made one of Russia's ten richest men over night. It was characterised as “the biggest robbery of the century, perhaps of human history”, Chernomyrdin became one of the largest shareholders (Gazprom was worth up to $700 billion) .


Mechanics of an Oligarch : Mechanics of an Oligarch Optimum level of Private Property Rights Political insiders utility at equilibrium is higher than at any other level, due to behaviour of corporate insiders and outsiders. Neither corporate insiders or outsiders are willing to pay large enough side-payments to political insiders to induce a change in Private Property Rights. Increase to private property rights Transfer effect - Improvements in PPR transfer wealth from existing users of capital to existing providers of capital. Cost of capital effect - Cost of external capital is lower, raises capital investment and is positive for outsiders. Competition effect – Entrepreneurs have more capital at their disposal to invest in projects, increasing competition. This has negative implications for corporate insiders and positive ones for outsiders.


Determinants of Economic Entrenchment : Determinants of Economic Entrenchment Four determinants: 1) Generic Considerations Corporate insiders will be more experienced in rent-seeking than in genuine entrepreneurship, and favour weak private property rights. Corporate insiders must be willing to pay more than outsiders. Political insiders preferences/needs – Do political insiders value side-payments more and economic growth less. level of democratic accountability, corruption, press power and education of the general public in the country.


Determinants of Economic Entrenchment : Determinants of Economic Entrenchment 2) Initial Endowment and Industrial Conditions William Easterly and Levine (2003) consider three hypotheses which contribute to a countries prosperity: Endowments hypothesis – Settler mortality, latitude, natural resources and access to the sea Institutions hypothesis – Private property rights, accountability, government, laws, regulatory burden and corruption Public policy hypothesis – Economic variables such as inflation, trade openness and exchange rate They found that endowments hypothesis, especially with regards to settler mortality and natural resources does explain growth, but only through their influence on institutions


Determinants of Economic Entrenchment : Determinants of Economic Entrenchment 3) Traditions – Political, Legal, Social and Cultural Democracy is an important factor – If outsiders substantially outvote insiders, political insiders should assign a lower weight to side-payments. Democratic nations are the work of the long term, rather than recent developments in the short term, so can be regarded as exogenous. E.g. Latin American countries intent on controlling the state to control natural resources, are actively opposed to democracy, to prevent the poor from gaining power a redistributing the wealth. In addition, an effective judiciary is important, as it is essential that the politics is up held, and taking bribes in punishable.


Determinants of Economic Entrenchment : Determinants of Economic Entrenchment 3) Traditions – Political, Legal, Social and Cultural Friedrich (1960) proposes that in Civil Code countries (France, Belgium), controlling elite use the judicial system to become entrenched, in contrast Common Law traditions (U.S. and Australia) with independent judiciaries are seen to protect private property rights. Free and independent press – A free press exposes and criticises manipulating political insiders, making lobbying less effective. Public education – A sound basic public education will mean that the general public with be able to argue their side for strong private property rights, and also produce more outsider entrepreneurs.


Determinants of Economic Entrenchment : Determinants of Economic Entrenchment 3) Traditions – Political, Legal, Social and Cultural Religion – Weber (1958) proposes that protestants by emphasising individual accountability, created a shift that favours entrepreneurs over old-money, in contrast to this hierarchal religions such as Roman Catholicism are less favourable to growth of large businesses. Rohan Williamson (2003) argues that a countries religion can be used as a more effective proxy for culture than factors such as income per capita and legislation, e.g. Catholic countries provide weaker rights to creditors than others do ad firms use less long-term debt.


Determinants of Economic Entrenchment : Determinants of Economic Entrenchment Globalisation To sustain economic entrenchment, a degree of economic autarchy is needed, this is for three reasons: Autarchy preserves monopoly, and if entrepreneurs can raise capital in functioning capital markets abroad, corporate controllers will lose out. Autarchy allows better control over capital barriers to stop innovators developing new products cutting into existing firms’ markets. Also trade barriers have the same effect by keeping foreign products out of domestic markets. Gives governments greater policy freedom for confiscatory taxes, skewed regulations and inefficient subsidies.


Criticisms : Criticisms This political economy framework is very basic and simplified for mean of clarity. The evolution of these institutions is obviously affected by more than corporate insiders and outsiders and lobbying political insiders, but gives us a good insight into how these factors relate to each other. Also, this assumes that governments are unitary and ignores complicated political processes associated with systems with substantial separation of powers, federal systems and other electoral systems.


Implications of Control Pyramids : Implications of Control Pyramids


Implications of Control Pyramids : Implications of Control Pyramids Capital Allocation Problems External Allocation Problems Capital Market Power Relationship Banking Problems Empirical Evidence Depressed Investment in Innovation Overall Capital Market Effects


External Allocation Problems : External Allocation Problems Physical capital might be overused within conglomerates and business groups in that more productive applications outside of the groups are forgone. They deduce that the more efficiently capital is allocated within a conglomerate or group, the greater the likelihood that capital is misallocated overall.


Capital Market Power : Capital Market Power Assume that a pyramidal group has a surplus of capital so large that it has a considerable “market share” in the supply of capital. The group would supply capital for internal and external use until the two alternatives generated identical marginal returns. The marginal return of capital in an internal application is less than the external users’ marginal return.


Relationship Banking Problems : Relationship Banking Problems Pyramidal groups often contain major commercial, investment, merchant, or universal banks as member firms. Allows firms in a pyramidal group preferential access to bank financing. If the bank and borrower firm are in the same control pyramid, and so have the same ultimate owner, both information asymmetry and hold-up problems might be mitigated.


Empirical Evidence : Empirical Evidence Little empirical work examines capital allocation within and between family controlled pyramidal groups. Morck, Stangeland and Yeung (2000) report that Canadian firms controlled by old money families have elevated capital–labour. Attig, Fischer, and Gadhoum (2003) find that Canadian firms affiliated with pyramidal groups have greater capital expenditures than comparable non-affiliated firms.


Investment in Innovation : Investment in Innovation Growth is a process of creative destruction. Growth requires the continual creation of innovations based on new technology or a recombination of old technologies. Yet, innovations also cause the destruction of firms built around activities rendered obsolete. Tunnelling within pyramidal groups might actually mitigate the negative impact of creative self-destruction on investment on innovation.


Overall Capital Market Effects : Overall Capital Market Effects In economies where a few old families control large bands of the corporate sector, such governance problems, which economists typically think of as firm-level effects, might easily attain macroeconomic proportions. Also, by affecting the nature of capital markets, extensive pyramiding might more directly affect macroeconomic outcomes. For example, a prevalence of pyramidal groups in a country’s corporate sector might render the average firm more opaque to outside investors, both domestic and foreign, and this might induce both to place their savings elsewhere.


Summary : Summary A single insiders’ poor governance becomes a macroeconomic problem if she controls a pyramid that includes a substantial fraction of a country’s corporate assets. The structure of a control pyramid also leads to a variety of capital allocation distortions. By altering the overall investment level and by skewing the distribution of capital expenditure across groups, firms, and projects, these distortions can compromise economic growth. Control pyramids might adversely affect investment in innovation because they internalize the disruptive effects of one firm’s innovation upon another. the concentration of capital within opaque pyramidal groups might raise public investors’ required returns by raising the levels of risk they perceive.